Introduction 

In view of the important role that broker’s brokers play in the provision of secondary market liquidity for municipal securities owned by retail investors, MSRB Rule G-43 sets forth particular rules to which broker’s brokers are subject.  Rule G-43(a)(i) provides:

Each dealer acting as a "broker’s broker"[1] with respect to the execution of a transaction in municipal securities for or on behalf of another dealer shall make a reasonable effort to obtain a price for the dealer that is fair and reasonable in relation to prevailing market conditions.  The broker’s broker must employ the same care and diligence in doing so as if the transaction were being done for its own account.[2]

In guidance on broker’s brokers issued in 2004,[3] the MSRB noted the role of some broker’s brokers in large intra-day price differentials of infrequently traded municipal securities with credits that were relatively unknown to most market participants, especially in the case of “retail” size blocks of $5,000 to $100,000.  In certain cases, differences between the prices received by the selling customers as a result of a broker’s broker bid-wanted and the prices paid by the ultimate purchasing customers on the same day were 10% or more.  After the securities were purchased from the broker’s broker, they were sold to other dealers in a series of transactions until they eventually were purchased by other customers.  The abnormally large intra-day price differentials were attributed in major part to the price increases found in the inter-dealer market occurring after the broker’s brokers’ trades.

Rule G-43 addresses the role of broker’s brokers, including their role in such a series of transactions.  It is the role of the broker’s broker to conduct a properly run bid-wanted or offering and thereby satisfy its duty to make a reasonable effort to obtain a price for the dealer that is fair and reasonable in relation to prevailing market conditions.  The MSRB believes that a bid-wanted or offering conducted in the manner provided in Rule G-43 will be an important element in the establishment of a fair and reasonable price for municipal securities in the secondary market.  This notice addresses the roles of other transaction participants, specifically the brokers, dealers, and municipal securities dealers (“dealers”) that sell, and bid for, municipal securities in bid-wanteds and offerings conducted by broker’s brokers.  Those selling dealers (“sellers”) and bidding dealers (“bidders”) also have pricing duties under MSRB rules and their failure to satisfy those duties could negate the reasonable efforts of a broker’s broker to achieve fair pricing.

Duties of Bidders

Rule G-13(b)(i) provides that, in general, “no broker, dealer or municipal securities dealer shall distribute or publish, or cause to be distributed or published, any quotation relating to municipal securities, unless the quotation represents a bona fide bid[4] for, or offer of, municipal securities by such broker, dealer or municipal securities dealer.”  Rule G-13(b)(ii) provides that “[n]o broker, dealer or municipal securities dealer shall distribute or publish, or cause to be distributed or published, any quotation relating to municipal securities, unless the price stated in the quotation is based on the best judgment of such broker, dealer or municipal securities dealer of the fair market value of the securities which are the subject of the quotation at the time the quotation is made.”

Dealers that submit bids to broker’s brokers that they believe are below the fair market value of the securities or that submit “throw-away” bids to broker’s brokers do so in violation of Rule G-13.  While bidders are entitled to make a profit, Rule G-13 does not permit them to do so by “picking off” other dealers at off-market prices.  Throw-away bids, by definition, violate Rule G-13, because throw-away bids are arrived at without an analysis by the bidder of the fair market value of the municipal security that is the subject of the bid.  A conclusion by the bidder that a security must be worth “at least that much,” without any knowledge of the security or comparable securities and without any effort to analyze the security’s value is not based on the best judgment of such bidder of the fair market value of the securities within the meaning of Rule G-13(b)(ii).  When the MSRB first proposed Rule G-13, it explained in a February 24, 1977 letter from Frieda Wallison, Executive Director and General Counsel, MSRB, to Lee Pickard, Director, Division of Market Regulation, Securities and Exchange Commission that, among the activities that Rule G-13 was designed to prevent was the placing of a bid that is “pulled out of the air,” which is another way to describe a throw-away bid.

Furthermore, when a dealer’s bid is accepted and a transaction in the securities is executed, that transaction price (and accordingly the bid itself) will be disseminated within the meaning of Rule G-13(a)(i) on the MSRB’s Electronic Municipal Market Access (EMMA®) platform within 15 minutes after the time of trade.  At that point, if the bid is off-market, it will create a misperception in the municipal marketplace of the true fair market value of the security.  The fact that the bid price that wins a bid-wanted or offering may well not represent the true fair market value of the security is evidenced by the trade activity observed by enforcement agencies following such auctions.  Enforcement agencies have informed the MSRB that they continue to observe the same kinds of series of transactions in municipal securities that prompted the MSRB’s 2004 pricing guidance.  They have also informed the MSRB about their observations of other trading patterns that indicate some market participants may misuse the role of the broker’s broker in the provision of secondary market liquidity and may cause retail customers who liquidate their municipal securities by means of broker’s brokers to receive unfair prices.

Duties of Sellers

Dealers that use the services of broker’s brokers to sell municipal securities for their customers also have significant fair pricing duties under Rule G-30 when they act as a principal.  As the MSRB noted in its request for comment on Draft Rule G-43,[5]

the information about the value of municipal securities provided to a selling dealer by a broker’s broker is only one factor that the dealer must take into account in determining a fair and reasonable price for its customer.  In fact, in 2004, the National Association of Securities Dealers (“NASD”) announced that it had fined eight dealers for relying solely on prices obtained in bid-wanteds conducted by broker’s brokers, which the NASD found to be significantly below fair market value.[6]  In that same year, the MSRB said that “particularly when the market value of an issue is not known, a dealer . . . may need to check the results of the bid wanted process against other objective data to fulfill its fair pricing obligations . . . .”

Under those circumstances where broker’s brokers seeks to satisfy their fair pricing obligations in bid-wanteds conducted pursuant to Rule G-43(b), Rule G-43(b)(v) provides for notice by broker’s brokers to sellers when bids in bid-wanteds are below predetermined parameters that are designed to identify possible off-market bids (e.g., those based on yield curves, pricing services, recent trades reported to the MSRB’s RTRS System, or bids received by broker’s brokers in prior bid-wanteds or offerings).  Once a seller has received such notice, it must direct the broker’s broker as to whether to execute the trade at that price.  That notice by the broker’s broker and required action on the part of the seller should put the seller on notice that it must take additional steps to ascertain whether the high bid provided to it by the broker’s broker is, in fact, a fair and reasonable price for the securities.  Rule G-30 mandates that the seller, if acting as a principal, must not buy municipal securities from its customer at a price that is not fair and reasonable (taking any mark-down into account), taking into consideration all relevant factors, including those listed in the rule.

The MSRB notes that Rule G-8(a)(xxv)(E) requires broker’s brokers to keep records when they have provided the seller with the notice described in Rule G-43(b)(v).  Among the required records are the full name of the person at the seller who received the notice, the direction given by the seller firm following the notice, and the full name of the person at the seller who provided that direction.

Rule G-43(b)(i) permits a broker’s broker to limit the audience for a bid-wanted at the selling dealer’s direction, a practice sometimes referred to as “screening” or “filtering,” because the MSRB recognizes that there may be legitimate reasons for this practice.  However, the MSRB notes that such screening may reduce the likelihood that the high bid represents a fair and reasonable price.  Selling dealers should, therefore, be able to demonstrate a reason that is not anti-competitive (e.g., credit, legal, or regulatory concerns), rather than trying to eliminate access by a competitor, for directing broker’s brokers to screen certain bidders from the receipt of bid-wanteds or offerings.  For example, a selling dealer might maintain a list of the firms it would be unwilling to accept as a counterparty and the reasons why.

The MSRB recognizes that there may be circumstances under which customers may need to liquidate their municipal securities quickly and that there are limitations on the ability of a bid-wanted or offering to achieve a price that is comparable to recent trade prices under certain circumstances, particularly in view of its timing and the presence or absence of regular buyers in the marketplace.  Nevertheless, the MSRB urges sellers not to assume that their customers need to liquidate their securities immediately without inquiring as to their customers’ particular circumstances and discussing with their customers the possible improved pricing benefit associated with taking additional time to liquidate the securities.

Rule G-17 requires dealers, in the conduct of their municipal securities activities, to deal fairly with all persons and to not engage in any deceptive, dishonest, or unfair practice.  Broker’s brokers have informed the MSRB that many dealers place bid-wanteds and offerings with broker’s brokers with no intention of selling the securities through the broker’s brokers.  Some have noted that shortly thereafter they see the same securities purchased by dealers for their own accounts at prices that exceed the high bid obtained by the broker’s brokers by only a very small amount.  Other dealers have told the MSRB that they are skeptical of many of the bid-wanteds they see, because they think the bid-wanteds are only being used for price discovery by the selling dealers and are not real.  Accordingly, in many cases, they do not bid.  This use of broker’s brokers solely for price discovery purposes harms the bid-wanted and offering process by reducing bidders, thereby reducing the likelihood that the high bid in a bid-wanted will represent the fair market value of the securities.  Additionally, it causes broker’s brokers to work without reasonable expectation of compensation.  For those reasons, depending upon the facts and circumstances, the use of bid-wanteds solely for price discovery purposes may be an unfair practice within the meaning of Rule G-17.

a quotation shall be deemed to represent a "bona fide bid for, or offer of, municipal securities" if the broker, dealer or municipal securities dealer making the quotation is prepared to purchase or sell the security which is the subject of the quotation at the price stated in the quotation and under such conditions, if any, as are specified at the time the quotation is made.

[5] MSRB Notice 2011-18 (February 24, 2011).

[6] See https://www.finra.org/Newsroom/NewsReleases/2004/P011465.

Supervision of data processing functions.  I am writing in response to your letter of November 7, 1988 and our subsequent telephone conversation by which you requested an interpretation of the Board’s qualification requirements for municipal securities principals. You asked whether an individual, who is presently qualified as a representative, additionally must be qualified as a municipal securities principal because he has oversight and supervisory responsibility for the firm’s data processing department.

Board rule G-3(a)(i)[*] defines a municipal securities principal as a person directly engaged in the management, direction or supervision of one or more enumerated representative activities. Consequently, whether or not this individual must be qualified as a municipal securities principal depends on whether he is supervising such activities, i.e., whether the data processing department employees are functioning as municipal securities representatives.

You state that the data processing department assists this individual by performing the calculations necessary in the structuring of municipal bond issues and underwritings. Moreover, you note that the employees in the data processing department do not communicate with customers, including issuers, in carrying out their duties and that the above financial advisory and underwriting activities are otherwise supervised by a qualified municipal securities principal.

Based upon the facts set forth above, we are of the view that the individual described supervises only  clerical or ministerial functions, and he is therefore not a municipal securities principal within the meaning of Board rule G-3. MSRB interpretation of December 9, 1988.

[*] [Currently codified at rule G-3(b)(i)]

In December 1984, the Board published a notice providing guidance to dealers in determining whether certain transactions are inter-dealer or customer transactions for purposes of Board rules. Since the publication of this notice, the Board has continued to receive reports that inter-dealer transactions sometimes are erroneously submitted to automated confirmation/affirmation systems for customer transactions. This practice reduces the efficiencies of automated clearance since these transactions fail to compare in the initial comparison cycle. The Board is re-publishing the notice to remind dealers of the need to submit inter-dealer and customer transactions to the correct automated clearance systems.

The Board recently has been advised that some members of the municipal securities industry are experiencing difficulties in determining the proper classification of a contra-party as a dealer or customer for purposes of automated comparison and confirmation. In particular, questions have arisen about the status of banks purchasing for their trust departments and dealers buying securities to be deposited in accumulation accounts for unit investment trusts. Because a misclassification of a contra-party can cause significant difficulty to persons seeking to comply with the automated clearance requirements of rules G-12, and G-15, the Board believes that guidance concerning the appropriate classification of contra-parties in certain transactions would be helpful to the municipal securities industry.

Background

Rule G-12(f)(i) requires dealers to submit an inter-dealer transaction for automated comparison if the transaction is eligible for automated comparison .... Rule G-15(d)(ii) requires dealers to use an automated confirmation/affirmation service for delivery versus payment or receipt versus payment (DVP/RVP) customer transactions if the [transactions are eligible for automated confirmation and acknowledgement].

The systems available for the automated comparison of inter-dealer transactions and automated confirmation/affirmation of customer transactions are separate and distinct. As a result, misclassification of a contra-party may frustrate efficient use of the systems. For example, a selling dealer in an inter-dealer transaction may misclassify the contra-party as a customer, and submit the trade for confirmation/affirmation through the automated system for customer transactions while the purchaser (correctly considering itself to be a dealer) seeks to compare the transaction through the inter-dealer comparison system. Since, the automated systems for inter-dealer and customer transactions are entirely separate, the transaction will not be successfully compared or acknowledged through either automated system.

Transactions Effected by Banks

The Board has received certain questions about the proper classification of contra-parties in the context of transactions effected by banks. A bank may be the purchaser or seller of municipal securities either as a dealer or as a customer. For example, a dealer may sell municipal securities to a bank's trust department for various trust accounts. Such purchases by a bank in a fiduciary capacity would not constitute "municipal securities dealer activities" under the Board's rules[1] and are properly classified and confirmed as customer transactions. A second type of transaction by a bank is the purchase or sale of securities for the dealer trading account of a dealer bank. The bank in this instance clearly is acting in its capacity as a municipal securities dealer and the transaction should be compared as an inter-dealer transaction.

A dealer effecting a transaction with a dealer bank may not know whether the bank is acting in its capacity as a dealer or as a customer. The Board is of the view that, in such a case, the dealer should ascertain the appropriate classification of the bank at the time of trade to ensure that the transaction can be compared or confirmed appropriately. The Board anticipates that dealer banks will assist in this process by informing contra-parties whether the bank is acting as a dealer or customer in transactions in which the bank's role may be unclear to the contra-party.

Transactions by Dealer Purchasing Municipal Securities for UIT Accumulation Accounts

The Board has also received several inquiries concerning the appropriate classification of a dealer who purchases municipal securities to be deposited into an accumulation account for ultimate transfer to a unit investment trust (UIT). The dealer buying securities for a UIT accumulation account may purchase and hold the securities over a period of several days before depositing them with the trustee of the UIT in exchange for all of the units of the trust; during this time the dealer is exposed to potential market risk on these securities positions. The subsequent deposit of the securities with the trustee of the UIT in exchange for the units of the trust may be viewed as a separate, customer transaction between the dealer buying the accumulation account and the trust. The original purchase of the securities by the dealer for the account then must be considered an inter-dealer transaction since the dealer is purchasing for its own account ultimately to execute a customer transaction. The Board notes that the SEC has taken this approach in applying its net capital and customer protection rules to such transactions.

The Board is of the view that, for purposes of its automated comparison requirements, transactions involving dealers purchasing for UIT accumulation accounts should be considered inter-dealer transactions. The Board also notes the distinction between this situation, in which a dealer purchases for ultimate transfer to a trust or fund, and situations where purchases or sales of municipal securities are made directly by the fund, as is the case with purchases or sales by some open-end mutual funds. These latter transactions should be considered as customer transactions and confirmed accordingly.

Other Inter-Dealer Transactions

In addition to questions on the status of a dealer bank and dealers purchasing for accumulation accounts, the Board has received information that a few large firms are sometimes subtracting trades with regional securities dealers into the customer confirmation system. The Board is aware that these firms may classify transactions with regional dealers or bank dealers as "customer" transactions for purposes of internal accounting and compensation systems. The Board reminds industry members that transactions with other municipal securities dealers will always be inter-dealer transactions and should be compared in the inter-dealer automated comparison system without regard to how the transactions are classified internally within a dealer's accounting systems. The Board believes it is incumbent upon those firms who misclassify transactions in this fashion to promptly make the necessary alterations to their internal systems to ensure that this practice of misclassifying transactions is corrected.

[1] Section 3(a)(30) of the Securities Exchange Act of 1934 defines a bank to be a municipal securities dealers if it "is engaged in the business of buying and selling municipal securities for its own account other than in a fiduciary capacity." For purposes of the Board's rule G-1, defining a separately identifiable department or division of a bank dealer, the purchase and sale of municipal securities by a trust department would not be considered to be "municipal securities dealer activities."

NOTE: Revised to reflect subsequent amendments.

Advertisements showing current yield. This is in response to your letter concerning the application of rule G-21, on advertising, to advertisements that include information on current yield of municipal securities. [1] You have asked for the Board’s views whether including current yield information in advertisements for municipal securities, alone or with other yield information, would be materially misleading. You also ask if a dealer may advertise current yield if other yield information is included but is in smaller print. The Board has considered this issue and authorized this reply.

Rule G-21 prohibits a dealer from publishing an advertisement concerning a municipal security that the dealer knows or has reason to know is materially false or misleading. The Board has stated that an advertisement showing a percentage rate of return must specify whether it is the coupon rate or the yield. The Board noted that, if a yield is presented, the advertisement must indicate the basis on which the yield is calculated.[2]

The Board frequently has stated that the yield to call or yield to maturity is the most important factor in determining the fairness and reasonableness of the price of any given transaction in municipal securities. Such yields typically are used as a basis for dealers and customers to evaluate an investment in municipal securities. The disclosure of yield to call or yield to maturity is the longstanding practice of the municipal securities industry and this practice is reflected in rule G-15(a) which requires dealers to disclose yield to call or yield to maturity on customer confirmations.[3] A customer who purchases a municipal security relying only on the current yield information disclosed in an advertisement would be confused upon receipt of the confirmation when the yield to call or yield to maturity of the security is different. Moreover, a customer would not be able to compare municipal securities advertised at a current yield with those advertised at a yield to call or yield to maturity.[4]

The Board has determined that the use of current yield information in municipal securities advertisements without other yield information would be materially misleading under rule G-21. Thus, dealers may not show only current yield in municipal securities advertisements.

The Board also has determined that, while showing only current yield information in advertisements is materially misleading, if advertisements also include, at a minimum, the lowest of yield to call or yield to maturity, current yield may be used if all the information is clearly presented as discussed below. The Board notes that including yield to call or yield to maturity in municipal securities advertisements would give customers a more realistic view of the yield they can expect to receive on the investment and would enable them to compare the security advertised with other municipal securities. In addition, the yield to call or yield to maturity information would be consistent with the yield information disclosed on customer confirmations. If the yield to call is used, the call date and price also should be noted.

The Board is concerned that, even if dealers comply with this interpretation of rule G-21 and include current yield and other yield information in municipal securities advertisements, such advertisements still could be misleading due to the size of type used and the placement of the information. For example, it would not be appropriate for the type size of the current yield to be larger than other yield information. Thus, whether a particular advertisement is materially misleading requires the appropriate regulatory body, for example, an NASD District Business Conduct Committee, to consider a number of objective and subjective factors. The Board urges the regulatory authorities to continue to review advertisements on a case-by-case basis to make a determination whether any such advertisements, in fact, are misleading. MSRB interpretation of April 22, 1988.

[1] Current yield is a calculation of current income on a bond. It is the ratio of the annual dollar amount of interest paid on a security to the purchase price of the security, stated as a percentage. If the securities are sold at par, the current yield equals the coupon rate on the securities. Current yield, however, does not take into account the time value of money. Thus, generally, if a bond is selling at a discount, the current yield would be less than the yield to maturity and, if the bond is selling at a premium, the current yield would be greater than the yield to maturity.

[2] Frequently Asked Questions Concerning Advertising, MSRB Reports, Vol. 3, No. 2 (Apr. 1983), at 21-23.

[3] Rule G-15(a)(i)(1) [currently codified at rule G-15(a)(i)(A)(5)] requires that the yield or dollar price at which the transaction was effected be disclosed on customer confirmations, with the resulting dollar price (if the transaction is done on a yield basis) or yield (if the transaction is done on a dollar basis) calculated to the lowest of dollar price or yield to call, to par option or to maturity. In cases in which the resulting dollar price or yield shown on the confirmation is calculated to call or par option, this must be stated and the call or option date and price used in the calculation must be shown.

[4] The Board also notes that some dealers have used current yield in municipal securities advertisements in an attempt to compete with municipal securities mutual funds, which often use a “current yield” in their advertisements. However, a mutual fund “yield” is not directly comparable to a municipal securities yield because a mutual fund “yield” represents historical information, while the yield on a municipal security represents a future rate of return.

The Board has received complaints regarding published quotations, such as those appearing in The Blue List. The complaints, which have been referred to the appropriate enforcement agency, state that municipal securities offerings published by dealers often do not reflect prices and amounts of securities that currently are being offered by the quoting dealer.

Board rule G-13, on quotations, prohibits the dissemination of a quotation relating to municipal securities unless the quotation represents a bona fide bid for, or offer of, municipal securities. The term quotation is defined to mean any bid for, or offer of, municipal securities. A quotation is deemed to be bona fide if the dealer on whose behalf the quotation is made is prepared to purchase or sell the municipal securities at the price stated and in the amount specified at the time the quotation is made.

Under rule G-13, the price stated in a quotation for municipal securities must be based on the best judgment of the dealer making the quotation as to the fair market value of such securities at the time the quotation is made. The Board has stated that the price must have a reasonable relationship to the fair market value of the securities, and may take into account relevant factors such as the dealer's current inventory position, overall and in respect to a particular security, and the dealer's anticipation of the direction of the market price for the securities.

Rule G-13 also prohibits a dealer from entering a quotation on behalf of another dealer if the dealer entering the quotation has any reason to believe that the quotation does not represent a bona fide bid for, or offer of, municipal securities. In addition, participants in a joint account are prohibited from entering quotations relating to municipal securities which are the subject of the joint account, if such quotations indicate more than one market for the same securities. Rule G-13 does not prohibit giving "nominal" bids or offers or giving indications of price solely for informational purposes as long as an indication of the price given is clearly shown to be for such purposes.

A dealer that publishes a quote in a daily or other listing must stand ready to purchase or sell the securities at the stated price and amount until the securities are sold or the dealer subsequently changes its price. If either of these events occur, the dealer must withdraw or update its published quotation in the next publication. Stale or invalid quotations violate rule G-13. Rule G-13 does permit a dealer to publish a quotation for a security it does not own if the dealer is prepared to sell the security at the price stated in the quotation. If the dealer knows that the security is not available in the market or is not prepared to sell the security at the stated price, the quotation would violate rule G-13.

Advertising of securities subject to alternative minimum tax. This is in response to your letter concerning the application of rule G-21, on advertising, to advertisements for municipal securities subject to the alternative minimum tax (AMT). You state that advertisements for municipal securities usually note that the securities are "free from federal and state taxes." You ask whether an advertisement for municipal securities subject to AMT should note the applicability of AMT if such advertisements describe the securities as "tax exempt." The Board has considered the issue and authorized this reply.

Rule G-21(c) prohibits a broker, dealer or municipal securities dealer from publishing any advertisement concerning municipal securities which the broker, dealer or municipal securities dealer knows or has reason to know is materially false or misleading. The Board has stated that the use of the term "tax exempt" in advertisements for municipal securities connotes that the securities are exempt from all federal, state and local income taxes. If this is not true of the security being advertised, the Board has required that the use of the term "tax exempt" in an advertisement must be explained, e.g., by footnote[1] In regard to municipal securities subject to AMT, the Board has determined that advertisements for such securities that describe the securities as being exempt from federal income tax also must describe the securities as subject to AMT. MSRB Interpretation of February 23, 1988.

[1] Frequently asked questions concerning advertising, MSRB Reports, Vol. 3, No. 2 (April 1983), at 22.